The Risk Of A U.S. Recession And Bear Market Due To Trade War With China

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, FXI, HGSFF, HGSXF, HSXUF, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SP500, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TLT, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: James A. Kostohryz
Summary

US equities are currently poised to make a series of new highs during the remainder of 2019.

A full-fledged trade war with China is one of the most important risks faced by the US economy and US equity investors.

A full-fledged trade war with China would have major global economic repercussions. Under certain circumstances, a US economic recession and an associated US equity bear market could be triggered.

A full-fledged trade war is highly unlikely due to political considerations in both the US and China.

The ongoing trade conflict between the US and China heated up on Sunday with a tweet from President Donald Trump threatening an escalation of tariffs.

The risk of a bear market for US equities is tied mainly to the risk of a US economic recession.

This article will focus on the question of whether an all-out trade war between the US and China could trigger a US recession.

Analysis of the News

President Donald Trump said in a twitter post on Sunday afternoon that the current tariff rate on $200 billion worth of Chinese goods will rise to 25% on Friday due to lack of sufficient progress in trade negotiations. He also threatened to impose 25% levies on an additional $325 billion of Chinese goods “shortly.”

Trump Tweets on Tariffs

President Trump’s statement represents a significant shift in rhetoric compared to optimistic statements coming from US officials in the past few weeks.

While it is difficult to know exactly how far apart the two sides are from making enough progress to avert Trump's threatened tariff escalation, President Trump’s statements certainly suggest - at the very least - that the two sides are currently further apart than many have been led to believe.

There are a number of major sticking points in the discussions, including differences on how to implement protections against intellectual property theft, how to structure enforcement mechanisms and a disagreement regarding whether tariffs should remain in place as a way to ensure Beijing honors its commitments. Trump officials seem to be particularly upset regarding some “backtracking” by China on previous commitments regarding technology transfer.

The Chinese had planned to bring a large delegation of negotiators to Washington on Wednesday, May 8, to hash out a trade deal. But various sources have reported that the Chinese side may back out of this week’s negotiations.

The Shanghai Composite Index was down by more than 6.0% and S&P 500 futures were down by more than 2.0% at midnight US Eastern time.

What Does A Trade War Potentially Mean For The US Economy?

The effects of a full “trade war” on the US economy would be very complex and are not easy to sort out. However, in assessing various scenarios, the following considerations are important to keep in mind.

  1. 25% tariffs on $540 billion worth of Chinese imports represents about 0.64% of US GDP.
  2. Since substitutes for Chinese goods can be sourced domestically and in other nations, the eventual direct cost impact of higher tariffs on US companies and consumers would be considerably less than 0.64% of GDP.
  3. However, supply chains in some industries are relatively inflexible, and a drastic increase in cost of critical components could cause serious troubles for some US businesses. This means that the indirect cost of tariffs on the US economy will be significantly greater than the direct impact of increased tariff costs.
  4. The most important - and least understood - factor to be taken into account is the impact that a trade war would have on the global economy. A trade war could trigger serious repercussions on the Chinese economy, which would, in turn, cause serious repercussions in many countries around the world. These repercussions will create a mix of positive and negative “blowback” effects on the US economy. A positive effect, for example, would be lower commodity prices. However, there would also be major negative effects via lower US exports to the rest of the world and financial contagion effects. The net impact on the US economy of these indirect international effects would likely be quite negative.
  5. China could choose to escalate the conflict and impose non-tariff measures, such as an outright ban on exports to the US of certain key products. The country could also implement a variety of measures aimed against US companies operating in China. This represents a real, although remote risk.

Two "Economic Warfare" Scenarios

1. Tariff war only. In a scenario of a prolonged tariff war that lasts for 12 months, the direct and indirect effects of a trade war could subtract 2.0% from US GDP growth. In this scenario, odds of a full-blown US recession being triggered are probably in the 40% range.

2. Expanded economic warfare. In a more severe potential scenario, in which the Chinese retaliate with non-tariff measures and the conflict escalates, the economic damage would be significantly greater. The probability of a US recession in this scenario would definitely increase to more than 50%.

Does Either Side Have the Stomach To Fully Follow Through With Its Threats?

The short answer: No.

Let us examine the US situation first. Facing reelection, the probability that Donald Trump will risk an all-out trade war that would put the US economy in jeopardy is very low. Therefore, the likelihood that 25% tariffs will be imposed for a prolonged period is quite low.

The Chinese, in many ways, are less likely to risk an all-out trade war. Currently, the Chinese economy is very vulnerable to a trade shock due to massive debt burdens accumulated in recent years in the private corporate sector and in state and local governments. Chinese officials understand that a major slowdown in the economy could trigger an unpredictable financial and economic crisis in China.

In my view, the cost of a full-fledged trade conflict is so high for both sides that the likelihood of the parties reaching an agreement - or at least agreeing to hold off on punitive trade measures - is quite high.

Conclusion

As I emphasize continually in Successful Portfolio Strategy, the risk of a US economic recession is the most important risk faced by US equities. A major trade war with China would substantially increase this risk.

In my view, many analysts underestimate the overall effects that a trade war would have on the US economy. The combined impacts of supply chain disruptions, declining global growth and global financial contagion are very large. These risks are not sufficiently appreciated by most analysts.

However, in my view, the risk of an all-out trade war with China is quite low, for political reasons. I do not believe that President Trump is willing to risk a recession in an election campaign season. Furthermore, Chinese leaders are probably even less willing to risk an all-out trade war, as the potential negative consequences for the Chinese economy are even greater than they are in the US.

Therefore, any major sell-off due to fears of a US-China trade war is probably a buying opportunity. I will be adding to equity positions in the portfolio I manage for Successful Portfolio Strategy, if key technical support levels which I discuss there are approached.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.